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CHAPTER 3

CHAPTER 3. Analysis of Financial Statements. Topics in Chapter. Ratio analysis Du Pont system Effects of improving ratios Limitations of ratio analysis Qualitative factors. Determinants of Intrinsic Value: Using Ratio Analysis. Net operating profit after taxes. Required investments

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CHAPTER 3

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  1. CHAPTER 3 Analysis of Financial Statements

  2. Topics in Chapter • Ratio analysis • Du Pont system • Effects of improving ratios • Limitations of ratio analysis • Qualitative factors

  3. Determinants of Intrinsic Value: Using Ratio Analysis Net operating profit after taxes Required investments in operating capital − Free cash flow (FCF) = FCF1 FCF2 FCF∞ ... Value = + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)∞ Weighted average cost of capital (WACC) Market interest rates Firm’s debt/equity mix Cost of debt Cost of equity Market risk aversion Firm’s business risk

  4. Overview • Ratios facilitate comparison of: • One company over time • One company versus other companies • Ratios are used by: • Lenders to determine creditworthiness • Stockholders to estimate future cash flows and risk • Managers to identify areas of weakness and strength

  5. Income Statement

  6. Balance Sheets: Assets

  7. Balance Sheets: Liabilities & Equity

  8. Other Data

  9. Five Categories of Fin. Ratios • Liquidity • Asset Mgmt • Debt Mgmt • Profitability • Market Value

  10. Five Categories of Fin. Ratios • Liquidity: Ability to meet current obligations • Asset Mgmt: Proper & effective use of assets • Asset utilization (i.e., Total Asset Turnover Ratio: • TAT = Sales / T. Assets • Debt Mgmt: extent of debt & level of safety afforded creditors • Debt utilization (i.e., Equity Multiplier: • EM = T. Assets / T. Eqty

  11. Five Categories of Fin. Ratios • Profitability: reflects effects of liquidity, asset mgmt, & debt on operating results • Expense Control: Profit Margin: • PM = Net Income / Sales • Market Value: indicators of what investors think of firm’s past results & future prospects

  12. Liquidity Ratios • Can the company meet its short-term obligations using resources it currently has on hand?

  13. Forecasted Current and Quick Ratios for 2011. $2,680 $1,040 CA CL CR10 = = = 2.58. CA - Inv. CL QR10 = $2,680 - $1,716 $1,040 = = 0.93.

  14. Comments on CR and QR • Expected to improve but still below industry average. • Liquidity position is weak.

  15. Asset Management Ratios • How efficiently does firm use its assets? • How much does firm have tied up in assets for each dollar of sales?

  16. Sales Inventories 2011E 2010 2009 Ind. Inv. T. 4.1 4.5 4.8 6.1 Inventory Turnover Ratio vs. Industry Average Inv. turnover = = = 4.10. $7,036 $1,716

  17. Comments on Inventory Turnover • Inventory turnover: • Firm might have old inventory, or its control might be poor. • No improvement is currently forecasted. Below industry average

  18. DSO: average number of days from sale until cash received. Receivables Average sales per day DSO = = = = 45.5 days. $878 $7,036/365 Receivables Sales/365

  19. 2011 2010 2009 Ind. DSO 45.5 39.5 37.4 32.0 Appraisal of DSO • Firm collects too slowly, and situation is getting worse. • Poor credit policy.

  20. Fixed Assets and Total AssetsTurnover Ratios Fixed assets turnover Sales  Net fixed assets = = = 8.41. $7,036 $837 Total assets turnover Sales Total assets = = = 2.00. $7,036 $3,517

  21. Fixed Assets and Total AssetsTurnover Ratios • FA turnover: • TA turnover not up to industry average. Implication? expected to exceed industry average. Good. Caused by excessive current assets (A/R and inventory).

  22. Debt Management Ratios • Does company have too much debt? • Can company’s earnings meet its debt servicing requirements?

  23. Calculate the debt, TIE, and EBITDA coverage ratios. Total liabilities Total assets Debt ratio = = = 43.8%. $1,040 + $500 $3,517 EBIT Int. expense TIE = = = 6.3. $502.6 $80 (More…)

  24. EBITDA Coverage (EC) + Lease payments + Depr. & Amort. EBIT _________ = = 5.5. Interest expense + Lease Pmt. + Loan pmt. $502.6 + $120 + $40 $80 + $40 + $0

  25. 2011E 2010 2009 Ind. D/A 43.8% 80.7% 54.8% 50.0% TIE 6.3 0.1 3.3 6.2 EC 5.5 0.8 2.6 8.0 Debt Management Ratios vs. Industry Averages Recapitalization improved situation, but lease pmtsdrag down EBITDA Cov.

  26. Equity Multiplier = T. Assets/Cmn Eqty • Firms with large amts of debt financing (high leverage) have high Eqty Multiplier • Think: Assets = Debt + Eqty

  27. Equity Multiplier = T. Assets/Cmn Eqty • Firms with small amts of debt financing (low leverage) have smaller Eqty Multiplier

  28. Profitability Ratios • What is company’s rate of return on: • Sales? • Assets?

  29. NI Sales EBIT Sales $503 $7,036 $253.6 $7,036 PM = = = 3.6%. OM = = = 7.1%. Net profit margin (PM): Operating profit margin (OM): (More…) Profit Margins

  30. Profit Margins (Continued) Gross profit margin (GPM): Sales − COGS Sales $7,036 − $5,800 $7,036 GPM = = $1,236 $7,036 GPM = = 17.6%.

  31. 2011E 2010 2009 Ind. PM 3.6% -1.6% 2.6% 3.6% OPM 7.1 0.3 6.1 7.1 GPM 17.6 14.6 16.6 15.5 Profit Margins vs. Industry Averages Very bad in 2010, but projected to meet or exceed industry average in 2011.

  32. Basic Earning Power & Subway vs. Smelly Deli • EBIT= • T.Assets= • BEP= EBIT/TA

  33. EBIT Total assets BEP = = = $502.6 $3,517 Basic Earning Power (BEP) =14.3%

  34. 2011E 2010 2009 Ind. BEP 14.3% 0.6% 14.2% 17.8% Basic Earning Power vs. Industry Average • BEP removes effect of taxes and financial leverage. Useful for comparison. • Projected to be below average. • Room for improvement.

  35. NI Total assets ROA = = = 7.2%. $253.6 $3,517 (More…) Return on Assets (ROA)and Return on Equity (ROE)

  36. NI Common Equity ROE = = = 12.8%. $253.6 $1,977 (More…) Return on Assets (ROA)and Return on Equity (ROE)

  37. 2011E 2010 2009 Ind. ROA 7.2% -3.3% 6.0% 9.0% ROE 12.8% -17.1% 13.3% 18.0% ROA and ROE vs. Industry Averages Both below average but improving.

  38. Effects of Debt on ROA & ROE No Debt (unlevered) vs. Debt (levered)

  39. Effects of Debt on ROA and ROE • ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. • However, use of debt lowers equity, and if equity is lowered more than net income, ROE increases.

  40. Important Implications of Debt Financing (Financial Leverage) • By raising $ thru debt, stockholders can maintain control of firm w/o increasing their investment. • Greater the equity stake, the less risk faced by lenders (creditors) • If company earns greater return on investment financed with debt than it pays in interest on borrowed funds, then it the return on owners equity is magnified, or leveraged.

  41. The Internal Growth Rate • The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. • Intrnl Grth rate = (ROA x Retention %) 1- (ROA x Retention %)

  42. The Sustainable Growth Rate • The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio. • Sustnbl Grth rate = (ROE x Retention %) 1- (ROE x Retention %)

  43. Market Value Ratios • Market value ratios: gives mgmt indication of what investors think of co.’s past performance & future prospects

  44. Market Value Ratios • Increase /decrease: • High current levels of earnings and cash flow increase market value ratios • High expected growth in earnings and cash flow increases market value ratios • High risk of expected growth in earnings and cash flow decreases market value ratios

  45. Market Value Ratios • P/E = Mrkt price per share / Earning per share • PEG ratio= (Price/Earnings) / Growth PEG <1.0 reflects fairly valued stock • M/B= Mrkt price p.s. / Book Value p.s. • P/CF=Price p.s. / CF p.s.

  46. Price = $12.17. EPS = = = $1.01. P/E = = = 12. NI Shares out. $253.6 250 Price per share EPS $12.17 $1.01 Calculate and appraise theP/E, P/CF, and M/B ratios.

  47. CF per share = = = $1.49. NI + Depr. Shares out. $253.6 + $120.0 250 Price per share Cash flow per share P/CF = = = 8.2. $12.17 $1.49 Market Based Ratios

  48. Com. equity Shares out. BVPS = = = $7.91. $1,977 250 Mkt. price per share Book value per share M/B = = = 1.54. $12.17 $7.91 Market Based Ratios (Continued)

  49. Interpreting Market Based Ratios • P/E: How much investors will pay for $1 of earnings. Higher is better. • M/B: How much paid for $1 of book value. Higher is better. • P/E and M/B are high if ROE is high, risk is low.

  50. Market Value Measures • Value Stocks: Firms w/ low Mrkt to Book ratios • Growth Stocks: Firms w/ high Mrkt to Book ratios • Market Capitalization = Mrkt Value of Common Equity • Enterprise Value= MV equity + MV debt – Cash – mrktbl securities. Measures value of firm’s underlying business

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